Chapter 11: Inflation

Inflation A continuous rise of the general price level General price level is measured by the Consumer Price Index (CPI): The weighted average price of 400 goods & services sold in urban areas around the nation.

Inflation Rate Percentage change of the CPI over the previous period Inflation stayed under 5% during the 1960s It averaged 7.7% in the first half and 10.6% in the second half of the 1970s Since the early 1980s, inflation rate has declined to as low as 3% in the late 1990s

Demand-Pull Inflation Inflation caused by an increase in the level of Aggregate Demand (1960s) At full employment, expansion of the Aggregate Demand is inflationary with no additional output

Price Level Output of Goods & Services S S D1 Full employment output 120 D2 D3 Demand-Pull Inflation

Cost-Push Inflation Inflation caused by an decrease in the level of Aggregate Supply (1970s & early 1980s) Higher general price level and falling output of goods & services result in stagflation, inflation plus stagnation

Cost-Push Inflation Price Level Output of Goods & Services S1 S D D Full employment output S S3

Effects of Inflation Equity effect: changing the pattern of income distribution from wage-earners to profit-makers Efficiency effect: requiring greater investment in hedging against inflation in labor & business contracts Output effect: recession resulting from cost-push inflation

Functions of Money Medium of Exchange Measure of Value Store of Value

Characteristics of Money Limited in supply Widely accepted Portable Divisible Uniform Durable

Money Supply Narrow definition: M1 –Currency: coins & bills (25%) –Demand Deposits: checking account deposits (75%)

Money Supply Broad definition: M2 –M1 –Time Deposits: savings account deposits (less than $100,000)

Money Supply Line The quantity of money in circulation is controlled by the central bank Quantity of Money Interest Rate (%) S S

Money Demand The amount of money demanded for transaction and speculative purposes depends: personal income and interest rate At any level of personal income, quantity demanded of money is a negative function of interest rate

Money Demand Line Quantity of Money Interest Rate (%) D D

Money Market Equilibrium Quantity of Money Interest Rate (%) D D 5 80 S S

Federal Reserve System, FED The central bank of the U.S. Independent decision making unit with regional banks In charge of money supply management and economic stabilization

Tools of Monetary Policy Legal reserve ratio: ratio of cash reserves to deposits that banks are required to maintain By lowering the ratio, banks will have more reserves to lend and invest, increasing the money supply

Tools of Monetary Policy Discount rate: rate of interest the FED charges on loans to banks By lowering the rate, banks encourage borrowing from the FED and lending to the public, increasing the money supply

Tools of Monetary Policy Open Market Operations: FED’s purchases and sales of government bonds By purchasing bonds and paying the sellers, the FED increases the money supply

Expansionary Monetary Policy Increase the money supply by any one or combination of the above tools Reduce the interest rate to encourage investment Increase Aggregate Demand, creating employment & income

Expansionary Monetary Policy Quantity of Money Interest Rate (%) D D 5 80 S S S’ 4 85

Quantity Theory of Money Equation of Exchange: MV = PQ –M = money supply –V = income velocity of money: the rate of turn over of money –P = general price level –Q = output of goods & services

Quantity Theory of Money Write: P = (V/Q) M Assuming V, Q, and V/Q constant, an increase in M causes a proportional increase in P Inflation is caused by a rapid growth of the money supply

Money Supply Growth & Inflation In 1960s, inflation was low and money supply growth constant at about 7% In the 1970s, inflation rose as the money supply grew at an increasing arte to reach 10% In the 1980s and 1990s, inflation fell as money supply grew at a declining rate to reach about 6%